Experts cite small-cap stocks they believe can survive slump

Focus put on a maker of agriculture tires, a little-known charter airline


December 30, 2007|By Andrew Leckey | Andrew Leckey,Tribune Media Services

With small-company stocks coming off a rocky year and heading into economic uncertainty, confidence in a traditional January small-cap rally isn't strong.

Investors tend to move up the market capitalization scale in times of stress to large companies, which are seen as carrying less risk than small firms. Big companies have a stronger financial foundation and typically aren't as dependent on credit markets to continue operation.

That may blunt the likelihood that year-end stock selling will create a rush of bargain hunters to small-cap stocks at the beginning of 2008. Historically, that phenomenon, the so-called January effect, often triggers a small-cap rise.

Different types of small-cap stocks have diverged this year, with the Russell 2000 growth index posting positive results, and the Russell 2000 value index down sharply.

But whether small caps cooperate fully as a group next year or not, it doesn't mean a number of stocks beaten down in 2007 couldn't become solid winners in the coming months.

"There is a tendency to throw the baby out with the bathwater when you make decisions on market cap rather than the soundness of an ongoing business," said Art Hogan, chief market strategist for Jefferies & Co. in New York. "There absolutely are good small-cap buys out there."

Although small caps could continue to struggle for a while, if the economic slowdown proves shallow and there's a second-half rebound, small-cap stocks will lead the way, Hogan said.

"The problem is deciding when you stick your toe in the water," he said. "If you wait for the green light to go on, it sometimes is too late."

His firm has "buy" recommendations on the stock of Hornbeck Offshore Services Inc., a supplier of vessels to the offshore oil and gas industry, and Array BioPharma Inc., specializing in small-molecule drugs for cancer and inflammatory diseases.

Other small caps that Jefferies & Co. likes include PharmaNet Development Group Inc., a provider of clinical-drug-development services for pharmaceutical, biotechnology, generic drug and medical-device firms; American Science & Engineering Inc., maker of X-ray and other inspection devices for homeland security; and Comtech Group Inc., which is in customized module design for electronics manufacturers in China.

Experts are looking for companies that can ride out a downturn.

"I try to stay away from companies that are economically sensitive, so the companies I cover are more recession-resistant," said Monica Logani, vice president for small-cap research at Wall Street Access in New York. "Even those stocks have been really whacked, and that's why I believe they are inefficiently priced right now."

Logani seeks management that investors can trust. Every small cap dreams of becoming a mid-cap, so investors should seek top managers who can navigate difficult economic cycles and take the firm to the next level.

"As the economy slows, [investors] should not invest in a small-cap index; it's about stock selection," Logani said. "I look for companies with good balance sheets, not too much debt and a nice amount of cash as a cushion."

One of her choices is ABX Air Inc., which does flying and sorting for the DHL America delivery network and also runs charter flights to other countries. It generates lots of cash but is trading at a "crazy" low valuation level, she said.

Another favorite is Titan International Inc., maker of tires for agricultural equipment and large mining trucks. It should see more farmers buy its products because financial returns from crops have been strong and many farmers haven't upgraded equipment in a decade, she said.

Other experts have their eyes trained overseas.

"About 18 months ago we made the decision to de-emphasize the consumer and financial sectors, anything with exposure to the yield curve or housing, and emphasize companies with a majority of revenues from international markets," said Ned Brines, senior vice president with Provident Investment Counsel, an institutional investment boutique in Pasadena, Calif. "So industrials, materials and technology now make up about half of our portfolio."

Brines is lead portfolio manager for the $21 million Provident Investment Counsel Small Cap Growth Fund. Although his institutional fund requires a $1 million minimum initial investment, which puts it out of reach of everyday investors, its major holdings are relevant:

InnerWorkings Inc., which serves as a matchmaker between print shops and client companies using their services, has carved out a stable and profitable niche that has significant growth potential.

CF Industries Holdings Inc., a producer of nitrogen and phosphate fertilizers for agriculture, has had sharp sales gains and is loaded with cash because of the expansion of crop acres in North America.

Equinix Inc., which operates centers for Internet businesses to place equipment and network facilities in major U.S. and Asian cities, is benefiting from a need for secure facilities with backup services and technical assistance.

Investors should keep in mind that consideration of small-cap stocks requires a continuing reality check.

Andrew Leckey writes for Tribune Media Services.

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